CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz curriculum note, study session 14, reading 26

Alternative Investments Portfolio Management INTRODUCTION Investors of alternative investments: • • • • Defined-benefit pension funds Endowments Foundations High-net worth individuals Rationale for Alternative Investments: Risk Diversification benefits i.e Role of Alternative Investments: • To meet return objectives • To control risk Six groups of Alternative Investments: • Returns over time are not highly correlated with traditional asset classes • Broaden fund’s investment “opportunity set” Ability to add value: Provides greater ability to investors to add value because Alternative asset classes are less “efficient” Return Enhancement: They can enhance total fund return and reduce risk (volatility) over time when combined with traditional assets Real estate Private equity Commodities Hedge funds Managed futures Distressed securities ALTERNATIVE INVESTMENTS: DEFINITIONS, SIMILARITIES, AND CONTRASTS Common features of alternative investments include: 1) Illiquidity: Relative illiquidity results in return premium demanded by investors • For investors with short investment horizons, illiquidity leads to small allocation to alternative investments • Long-term investors (e.g endowments and defined-benefit pension funds) can make large allocations and earn illiquidity premiums 2) Diversification benefits: Low correlations with traditional investments 3) High due diligence costs for the following reasons: a) Complex investment structures and strategies b) Uniqueness: Investment evaluation significantly depends on asset class, business specific or other expertise c) Lack of transparency in reporting 4) Difficulty in establishing valid benchmark and performance appraisal 5) Longer time horizons 6) Informationally less efficient relative to equity and bonds market 7) Offer greater opportunity to add value through skill and superior information NOTE: In both alternative and traditional investments, management fees, trading or operational expenses need to be justified and managed Traditional Alternative Investments: 1) Real Estate: It refers to ownership interests in land or structures attached to land 2) Private Equity: It refers to ownership interests in nonpublicly traded companies 3) Commodities: It refers to agricultural goods, metals, petroleum Modern Alternative Investments: These investments indicate investment and trading strategies (ways to invest/style of investing) 1) 2) 3) Hedge Funds Managed Futures Distressed Securities NOTE: Alternative investment can be placed in more than one category e.g distressed securities investing can be classified: • Within private equity if debt is considered to be private equity; • As a subcategory of event-driven strategies under hedge funds; • As a separate alternative investment strategy –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 26 Reading 26 Alternative Investments Portfolio Management FinQuiz.com 6) Service Providers: These refer to firms supporting from outside e.g lawyers, auditors, prime brokers, lenders etc 7) Documents: It involves reading prospectus, memorandum, audits etc 8) Write-up: It involves formally documenting the entire selection process and producing formal recommendation of manager Following are the Issues that are more acute or unique to private wealth clients than to institutional investors: Three groups of Alternative Investments: 1) Investments that provide exposure to unique risk factors (not provided by traditional investments) e.g real estate provides exposure to demographics and (longonly) commodities provide exposure to inflation 2) Investments that provide exposure to specialized investment strategies e.g hedge funds and managed futures 3) Investments that have combined features of exposure to unique risk factors and investment strategies e.g private equity funds and distressed securities Due Diligence process in Alternative Investments involve the following steps: 1) Market Opportunity: It involves identifying investment opportunities in the market, their causes and their chances of persistence It is done by analyzing capital markets and types of managers operating within those markets Tax issues: Alternative investments frequently involve partnerships and other structures that have distinct and peculiar tax issues Determining suitability: Determining suitability of investment is more complex in case of an individual client or family than for an institutional investor because of: • Uncertain time horizons of individual clients • Emotional or financial needs of a client Communication with client: Individuals are nonprofessional investors and have less knowledge, therefore, it is difficult for an advisor to communicate and discuss suitability of investment in the portfolio with them Decision risk: It refers to irrational trading/changing strategies at the point of maximum loss Decision risk increases due to the strategies with following characteristics: 2) Investment process: It involves evaluating managers’ comparative advantage etc • Strategy that involves negatively skewed returns • Strategies that involve high kurtosis 3) Organization: It involves valuating stability of the firm and how well it is organized i.e Consistent investment philosophy, less management (staff) turnover, fair compensation, succession plans etc Note: investors prefer positive skewness and moderate or low kurtosis 4) People: It involves analyzing experience, intelligence, integrity of the people in the firm 5) Terms and Structure: It refers to time and amount of investment and requires evaluating fair terms, alignment of interests, properly structured account etc Real estate plays an important role in both institutional and individual investor portfolios Note: The focus of this reading is only Equity investments in real estate Concentrated equity position of the client in a closely held company: It is necessary to take into account the effect of investment on the client’s risk and liquidity position when ownership in a closely held company represents a substantial part of wealth of the client NOTE: In core-satellite investing, alternative investments usually are included in the satellite ring for most investors REAL ESTATE 3.1 The Real Estate Market Rationale for investment in Real Estate by institutional investors i ii To diversify their portfolios To hedge against inflation Reading 26 Alternative Investments Portfolio Management 3.1.1) Types of Real Estate Investments A Direct ownership includes: Investment in residences Business (commercial) real estate i Industrial ii Apartments iii Offices iv Retail Agricultural land B Indirect investment (also known as financial ownership) includes investing in: Companies engaged in real estate ownership, development or management i.e homebuilders and real estate operating companies Real estate investment trusts (REITs) are publicly traded equities representing pools of money invested in real estate properties and/or real estate debt Commingled real estate funds (CREFs) are privately traded equities representing significant commingled (i.e pooled) investment in real estate properties Separately managed accounts managed by real estate advisors like in case of CREFs Infrastructure funds are private investment in public infrastructure projects i.e roads, schools, bridges, airports etc with rights to receive specified revenue streams over a contracted period Types of REITs: Equity REITs: Own and operate income-producing real estate i.e office buildings, apartment buildings and shopping centers • Shareholders receive rental income and income from capital appreciation if the property is sold for a gain FinQuiz.com 2) REITs are highly liquid as their shares trade on major exchanges 3) REITs allow smaller investors to get real estate exposure 4) ETFs, mutual funds and traded closed-end investment companies allow investors to obtain a professionally managed diversified portfolio of real estate securities with a relatively small outlay Disadvantages: 1) REIT returns are more volatile than real estate returns (due to public trading) 2) REITs have relatively higher correlation with equities than real estate prices Risk Hedging properties: • Hold property and want to sell it in future, short REITs index to hedge risk • Want to buy property, long REITs index CREFs: • CREFs include open-end funds and closed-end funds • CREFs are used by institutional and wealthy individual investors to access the real estate expertise of a professional real estate fund manager • In contrast to open-end funds, closed-end funds are usually leveraged and have higher return objectives (due to high risk); 3.1.2) Size of the Real Estate Market According to estimates, real estate represents one-third to one-half of the world’s wealth 3.2 Benchmarks and Historical Performance 3.2.1) Benchmarks Mortgage REITs: Mortgage REITs deal in the investment and ownership of property mortgages; • They loan money for mortgages to owners and operators of real estate or • Invest in (purchase) existing mortgages or mortgage-backed securities • Shareholders receive interest income on mortgage loans and capital appreciation income from improvement in the prices of loans Hybrid REITs: Hybrid REITs invest in both mortgages and properties, combining the investment strategies of Equity REITs and Mortgage REITs Advantages of REITs: 1) REITs securitize illiquid real estate assets NCREIF Index: The principal benchmark used to measure the performance of direct real estate investment is the National Council of Real Estate Investment Fiduciaries Property Index Characteristics: • It is issued quarterly • It covers a sample of commercial properties owned by large institutions • Value-weighted index • Includes sub-indices grouped by real estate sector (apartment, industrial, office and retail) and geographical region • Values are determined by property appraisals and conducted infrequently • Ownership change is infrequent • Smoothing effect due to appraised values: The Reading 26 Alternative Investments Portfolio Management use of appraised values tends to o Smooth the returns o Underestimate volatility in underlying values o Understate correlations with other assets o Overstate benefits of real estate in the portfolio • It is not an investable index (for performance appraisal) • NCREIF Index represents non-leveraged investment only • NCREIF Index most accurately represents the performance of private real estate funds Important Note: Using unsmoothed NCREIF Index more accurately reflects the benefits of real estate investment FinQuiz.com NCREIF Index • When NCREIF is unsmoothed, volatility more than doubles but return is increased by a small amount • Securitized real estate investments are poor substitutes for direct investment because: o Smooth NCREIF Index and Unsmooth NCREIF Index have high positive correlation (i.e 0.71) o The correlation between unhedged NAREIT Index and NCREIF Index is o The correlation between unhedged NAREIT Index and unsmoothed NCREIF Index is 0.21 Timberland and Farmland: NAREIT Index: The principal benchmark used to represent indirect investment in real estate is the NAREIT Index • • • It is a real time market (cap) weighted index of all REITs actively traded on the exchange • It computes a monthly index based on monthend share prices of REITs that own and manage real estate assets or equity REITs • REITs provide a levered exposure to real estate (> 50% of capital structure is represented by debt) Therefore, they have higher risk (higher S.D) relative to unsmoothed NCREIF Index • 3.3 Investing in timberland and farmland provides potential for substantial income and capital appreciation but bears limited liquidity Farmland returns rely on value of land and prices of agriculture commodities Timberland returns depend on land value and lumber prices The demand side of lumber depends on the housing starts and the supply side depends on the environmental conditions Investors can also invest in timber through timberland REITs Real Estate: Investment Characteristics and Roles Hedged REITs: Long REITs + Short Futures • The hedged NAREIT Index is a more realistic representation of the underlying real estate market and has high correlation with the unsmoothed NCREIF Index than without correction (although hedging is imperfect) • Hedged NAREIT Index is preferred because it eliminates double counting of equity return component in equity REITs It results in increase in return, decrease in risk and increase in Sharpe ratio 3.2.2) Historical Performance • It has been observed that the real estate market lags behind publicly traded real estate securities • Direct and indirect real estate investments produced better risk-adjusted performance over 1990-2004 period relative to general stocks and commodities Real estate represents a major portion of many individuals’ wealth However, the clients’ residences are not considered “marketable” and therefore, are not included in strategic asset allocation 3.3.1) Investment Characteristics Following are some of the investment characteristics of physical real estate market: 1) 2) 3) 4) 5) 6) Relative Lack of liquidity Large lot sizes and not divisible Relatively high transaction costs Heterogeneity Immobility (fixed location) Relatively low information transparency (seller has informational advantage relative to buyers) 7) Not easily traded due to market inefficiencies 8) Investment is long-term Implication: Difference between performance properties of direct and securitized real estate investment REITs (Indirect) High return High S.D Higher Volatility Direct (or appraisal-based) Low returns Low S.D Low volatility due to stale valuations • Downside bias is corrected by “un-smoothing” the 1) These characteristics provide opportunity to generate relatively high risk-adjusted returns for investors who can obtain cost-efficient and high quality information 2) Due to lack of reliable and high frequency transaction data for properties, valuations are appraisal-based Effect of market and economic factors on real estate: Reading 26 Alternative Investments Portfolio Management • Interest rates directly or indirectly affect demand and supply for real estate by affecting factors i.e business financing costs, employment levels, savings habits and the demand and supply for mortgage financing • Worldwide, the returns to real estate are positively correlated with changes in GDP • In the long run, population growth positively affects real estate returns Inflation-hedging: There are mixed conclusions regarding the inflation-hedging capabilities of real estate investment Overall, direct real estate investment can provide an inflation hedge to some degree Real estate values are affected by idiosyncratic variables i.e location This implies that: FinQuiz.com property compared to flexibility of trading small amounts in REITs on public exchanges • The lack of availability and timeliness of information results in extensive valuation and due diligence issues 3) High cost of acquiring information because of heterogeneity of real estate 4) High transaction costs because of high commissions charged by real estate brokers relative to securities transaction fees Exchange traded REITs have low transaction costs and reallocation of funds is easy 5) High Operating costs i.e greater maintenance, operating and administrative costs and hands-on management • Complete diversification in real estate can be achieved only by investing internationally • Optimal diversification can be obtained by selecting one country from each continent 6) Locality Risk: Have greater exposure to neighborhood deterioration and conditions that are not under investors’ control Advantages of DIRECT INVESTMENT in real estate (for both institutional and individual investors): 7) Political risks associated with tax benefits i.e income tax deductions can be discontinued in case of changes in tax laws 1) Tax benefits: Mortgage interest, property taxes and other expenses are tax deductible which benefits taxable owners of real estate 2) Use of high leverage: Greater financial leverage can be used in mortgage loans compared to securities investing 3) High control over investment: Real estate investors have direct control over their property and are able to expand or modernize property to increase its market value 4) Geographical Diversification: The values of real estate investments in different locations have low correlations; thus, it can be used to reduce exposures to catastrophic risks e.g floods etc 5) Low volatility: Real estate returns (on average) have relatively low volatility compared to public equities even after correcting for downward bias 6) Greater diversification benefits: Direct real estate has lower correlations with U.S equities and bonds relative to REITs’ correlations Disadvantages: 1) Large size and indivisibility: Direct investment in real estate is usually in large lots and is not easy to divide into smaller pieces Consequently, these properties constitute a major portion of an investor’s total portfolio and investors have to deal with large idiosyncratic risks associated with these investments 2) Illiquid relative to securitized real estate due to: • Large transaction sizes when buying/selling 3.2.2) Roles in the Portfolio Real estate is affected by many economic fundamentals and economic cycles Thus, these investments can be used for tactical allocation purposes by forecasting economic cycles that would positively affect these investments Real estate has a potential to add value through active management Real estate also provides diversification benefits • Historically, direct investment in real estate has shown low correlation with other assets • Real estate investments are less affected by shortterm economic conditions and therefore, have lower volatility than other asset classes Good income enhancer: Income producing commercial real estate is considered a relatively stable investment Real Estate Performance in Portfolios: Adding REITs to traditional portfolio of equities and bonds results in higher Sharpe ratio It does not provide diversification benefits when added to a portfolio consisting of stock/bond/ hedge funds and commodity Unsmoothed NCREIF Index has negative correlation with S&P 500 and bonds; this results in increase in Sharpe ratio when unsmoothed NCREIF Index is added to stock/bond portfolio However, Sharpe ratio is slightly increased when unsmoothed NCREIF Index is added to stock/bond Reading 26 Alternative Investments Portfolio Management portfolio with the added exposure of hedge funds and commodities 3) Unlike indirect investments, direct investments exhibit high degree of persistence in returns i.e positive following positive and negative following negative Conclusion: Direct real estate investment provides diversification benefits to stocks and bonds but benefits disappear when hedge funds and commodities are added to the portfolio Diversification within Real Estate Itself: Diversification within real estate investing can be obtained through type and geography Investments in different real estate sectors have different risk and return profiles Practice: Example 5, Volume 5, Reading 26 Rationale for including real estate in a multi-asset portfolio: Large office assets: • • • • FinQuiz.com Real estate has a low correlation with stocks and bonds Real estate (historically) has shown a high riskadjusted rate of return relative to stocks and bonds Real estate has a positive correlation with both anticipated and unanticipated inflation and therefore provides an inflation hedge Higher risk Higher volatility Lower risk-adjusted returns More pronounced impact of market cycles Apartments: • Lower risk • Lower volatility • Higher risk-adjusted returns (due to low correlation with inflation) Properties of Return Distribution of Real Estate: 1) Due to illiquid market (Direct investment), returns tend to be close to zero 2) Both direct and indirect investments have nonnormal distribution PRIVATE EQUITY/VENTURE CAPITAL Private equity is an ownership interest in a private (nonpublicly) company It includes start-up companies, middle-market private companies and private investment in public entities (PIPE) • Preferred stock is senior to common stocks both in terms of its profit share and liquidation value • Shares issued in later rounds of financing are senior to previously issued preferred stocks (all else constant) • Events i.e buyouts or acquisition of the common equity at a favorable price triggers the conversion of preferred stocks into common stocks Characteristics: • Private equity is not registered with a regulatory body • These involve Private placements i.e sale offers to either institutions or high-net-worth individuals (accredited investors) • Private equity plays a growth role in investment portfolios • Risk is controlled and evaluated through appropriate due diligence processes 4.1.1) Types of Private Equity Investment 1) Direct Investment: It refers to purchasing claim directly from the company that needs financing • Structured as convertible preferred stock rather than common stock 2) Indirect Investment: It is primarily done through private equity funds i.e VC and buyout funds • Structured as limited partnerships or limited liability companies (LLCs) • Have an expected life of 7-10 years with 1-5 years extension option • Commitment/offering period defines how committed funds will be requested over time • Investment in private equity is mostly done via private equity funds Advantages of Limited Partnerships and LLCs: Reading 26 i ii Alternative Investments Portfolio Management Avoid double taxation Liability of limited partners or shareholders is limited to their amount of investment General partner (managing director in LLCs): He is the venture capitalist who selects and advises investments to investors He also commits his own capital, which is helpful in closely aligning interest of outside investors and the fund manager Limited partners: Refer to shareholders of LLCs or limited partnerships FinQuiz.com • Restructuring operations and improving management • Purchasing companies at a discount to their intrinsic value • Creating gains by adding debt or restructuring of existing debt These funds seek to reduce costs and increase revenues and for this purpose, they generally maintain a pool of experienced operating and financial executives to be added to companies if necessary or appropriate Value gains can be realized through: NOTE: • Private equity funds usually not maintain a pool of uninvested capital • Private equity funds of funds are also available Private equity funds: These are pooled investment vehicles through which many investors make indirect investments in generally highly illiquid assets Major forms include a) Venture Capital (early, mid and late-stage): Private capital used to finance a start-up (new) business or growing private companies Characteristics: • Venture capital investments are private, nonexchange-traded equity investments • Investments are usually made through limited partnerships • Due to illiquidity and high risk, relatively high returns are expected • Private company eventually converts into publicly owned company • Have Capacity issues i.e limited investment opportunities • Requires distinct knowledge and experience b) Buyout Funds/Buyouts: Acquisition of an established company or an operating division via private equity funds known as buyout funds • Publicly owned company is converted into private • Buyout funds constitute a large portion of private equity fund relative to VC funds in terms of AUM or size of capital commitments Types of buyout funds: 1) Mega-cap buyout funds: These funds take public companies private 2) Middle-market buy-out funds: These funds purchase private companies (established and/or divisions spun-off from larger companies), which are not able to access capital from public due to small revenues and profits Value in these companies is added through: a) Sale of the acquired company b) IPO c) Dividend Recapitalization i.e debt is issued to finance special dividends to owners • Advantage: Facilitate investors to recover all or most of the investment within 2-4 years of the buyout along with the retention of ownership control • Disadvantage: Due to high leverage involved, a company may become weak 1) Private Investment in Public Entity (PIPE):It refers to making a relatively large investment in a public company usually at a significant discount when the share price of a publicly traded company drops significantly Investors of Private Equity include: • • • • • • Pension plans Endowments Foundations Corporations Family offices Other advisors to the private wealth market NOTE: Private placement memorandum: A document used for the purpose of raising funds through an agent Private Equity Investments Publicly Traded Securities Structure and Valuation Price and deal structure are determined through private negotiation between the investor and company management Price is determined by market Deal structure is standardized Securities regulators approve variations Access to Information for Investment Selection Investors can have access to all information (including internal projections) Investors have access to only publicly available information Post-Investment Activity Reading 26 Alternative Investments Portfolio Management Private Equity Investments Publicly Traded Securities Investors remain significantly involved in the management of the company after investment and participate at board level as well Investors have limited access to management and not participate at board level Practice: Exhibit 9, Volume 5, Reading 26 4.1 The Private Equity Market The Demand for/Issuers of Venture Capital: Formative-stage / start-up companies: • Newly formed companies and/or young companies beginning product development • Companies just start selling a product (through marketing an effective business plan to potentially interested parties) • Most Venture Capitalists are not interested in companies at their earliest stage Expansion-stage companies: • Young companies that need funds to expand sales • Established companies with significant revenues (middle-market companies) • Companies preparing for an IPO Financing stages of a private company include: Early-stage Financing: It is used by Formative-stage Companies It involves following sub-stages: Seed: In seed stage, small amount of money is provided to form a company or to prove commercial success of a business idea • Characteristics: Incorporation of business idea, first personnel is employed, development of prototype • Buyers/financing: Founders, FF&Fs, angel investors, venture capital • Purpose of financing: To support market research and to establish a business Start-up: In this stage, a company has been formed and idea has been proven but funds are needed to commercialize the product or idea • Characteristics: Pre-revenue stage i.e revenue has not yet started • Buyers/financing: Angel investors and venture FinQuiz.com capital • Purpose of financing: To support product development and initial marketing First-stage: When a company has been through seed and start-up stages and needs additional financing • Characteristics: Operation has started and revenue starts to initiate • Buyers/financing: Angel investors and venture capital • Purpose of financing: To support initial manufacturing and sales Later-stage Financing: It is used by Expansion-stage Companies who need funds to expand sales It involves following sub-stages: Second-stage: • Characteristics: A company that is already producing and selling a product and revenue starts to grow • Buyers/financing: Venture capital, strategic partners • Purpose of financing: To support initial expansion of a company Third-stage: • Characteristics: Revenue starts to grow • Buyers/financing: Venture capital, strategic partners • Purpose of financing: To provide funds for major expansion Pre-IPO: It refers to mezzanine stage • Characteristics: IPO preparation • Buyers/financing: Venture capital, strategic partners • Purpose of Mezzanine (bridge) financing: To provide funds to prepare for an IPO (mix of debt & equity) The Exit: The exit of a private equity is difficult Following are ways to exit: a) Merger with another company b) Acquisition by another company c) IPO In case of failure of venture, business can be closed without any recovery of the original investment by the equity holder Reading 26 Formative-Stage Companies Early Stage Alternative Investments Portfolio Management Seed Stage Financing (buyers of private equity) Purpose of Financing Idea incorporation, hiring of 1st personnel, prototype development Founder, FF&F, angles, venture capital Supports market research and establishment of business Movement into operation, initial revenues Angles, venture capital Supports product development & initial marketing Supports initial manufacturing & sales Revenue Growth Venture capital, strategic partners Supports initial expansion of a company already producing & selling a product Provides capital for major expansion Start-Up First Stage Expansion-Stage Companies Stage Characteristics Later Stage Second Stage Third Stage PreIPO Mezzanine Preparation for IPO FinQuiz.com Provides capital to prepare for the IPO-often a mix of debt & equity Reference: CFAI Curriculum, Reading 26, Exhibit 10 The Supply of Venture Capital: Suppliers of venture capital include the following and the investors are often referred to as “strategic partners” • These funds are not available to the public 1) Angel investors: The first outside investors in a company • Invest in seed and early-stage companies • Invest relatively a small amount • These investments are considered to be the riskiest because of early stage of business 2) Venture Capital (VC): Dedicated Pools of capital managed by specialists (venture capitalists) that provide equity or equity-linked financing to privately held companies An individual pool is known as venture capital fund Compensation of the Fund Manager: • VC identifies companies with attractive business opportunities • Provide financial and strategic support and expertise in related fields 3) Large Companies: Major companies invest in promising young companies in the same or related businesses • This investment is known as corporate venturing Management fee + Incentive fee A Management fee is usually a % of committed funds(not the amount actually invested) It ranges 1.5 – 2.5% and decreases over a period of time to reflect lower work load in later years of partnership B Incentive fee (a.k.a carried interest): It is the share of the private equity fund’s profit earned by manager after the fund has returned the outside investor’s capital (i.e Reading 26 Alternative Investments Portfolio Management FinQuiz.com profits that represent a return >hurdle rate or preferred rate) It is expressed as % of total profits of a fund i.e 20% Interpretational Issues: Incorrect returns are estimated due to: C Clawback provision: It is a provision to penalize the manager for bad performance in later years i.e manager is required to return money to investors if at the end of a fund’s life investors have not received back their capital contributions and contractual share of profits • Use of appraised values (stale data) • Significant effect of company-specific events • Non-standardized method of appraisals Distribution of cashflows: • First of all invested capital and preferred return is distributed to investors • Sometimes, manager is allowed to take small % of early distributions • When all or most of the cash flows are distributed to investors, in the following years there is a catch up period in which the manager receives all or most of the profits • Subsequent profits are then distributed to investors according to carried interest %, for example 80% to investors and 20% to manager • Some of the profits of the manager can be placed in an escrow account to meet claw-back liability, if any Vintage year Effects: The effect of vintage year (closing year of a fund) on fund’s returns is known as vintage year effect Investors should take into account vintage year effects when comparing performance of different private equity funds 4.3 Investment Characteristics and Roles of Private Equity 1) Illiquidity: Private equity investments are generally highly illiquid Convertible preferred stock investments not trade in the secondary market 2) Long-term commitments: Private equity investment requires long-term commitments Time horizon can also be quite uncertain for direct VC investments 3) Higher risk than seasoned public equity investment: Return: On average, returns have higher dispersion than public equity 4.1.2) Size of the Private Equity Market According to a reliable study, by 2006, around US$200 billion was invested in private equity VC and buyout funds via approximately 1,000 private equity vehicles 4.2 Risk: Risk of complete loss of investment is higher New and young businesses have higher failure rate 4) High expected IRR required: Investors require high target return to compensate for higher risk and illiquidity Benchmarks and Historical Performance Characteristics of VC investments further include: In private equity, events through which market price can be determined include: • • • • 5) • Ventures operate in new markets • Cash flows projections are based on limited information available and assumptions New funds raising Company acquisition by another company IPO Failure of the business 6) Benchmarks: Benchmarks include: i ii Cambridge association and Thomson Venture Economics Custom benchmarks Construction: Value depends on specific events Benchmarks are constructed for VC and buyouts Biases: Infrequent pricing process creates problems for index construction as a result of stale values Historical Performance: Private equity returns have exhibited low correlation with publicly traded securities which indicates that they can contribute to portfolio value addition However, low correlation might exist because of use of stale prices due to lack of observable market prices for private equity Limited information: High upside potential for successful ventures Differences between VC funds and Buyout funds: • Buyout funds are usually highly leveraged In contrast, VC funds not use debt to obtain their equity interests • Buyout funds have earlier and steadier cashflows relative to VC funds Note that Buyout funds are able to realize returns earlier due to purchase of established companies Note: The earlier the stage in which a fund invests in companies, the greater the risk and the higher the return potential • Buyout funds have less error in value measurement • VC investing (relative to buyout funds) are associated with frequent losses and higher upside Reading 26 Alternative Investments Portfolio Management potential when investments are successful • Buyout funds investment involves less risk and earlier returns Practice: Example 9, Volume 5, Reading 26 Treatment of nonmarketable interest: • The discount for a minority interest reflects the lack of control that the investor has over the business and distributions i.e Minority interest discount ($) = marketable controlling interest value ($) × minority interest(%) discount = (investor’s interest in the equity × total equity value) × minority interest discount(%) Marketable minority interest ($) = Marketable controlling interest value ($) – minority interest discount ($) • Discount for lack of marketability (marketability discount) reflects the lack of liquidity in the investment and depends on factors i.e size of the interest and level of dividends paid Marketability discount ($) = Marketable minority interest ($) × marketability discount (%) Non-Marketable minority interest ($) = Marketable minority interest ($) - marketability discount ($) • In case of valuing a controlling interest, we need to consider only the marketability discount • In case of valuing a majority interest, the discount for lack of marketability reflects both the cost of going public and a discount for owning a large block of shares Practice: Example 8, Volume 5, Reading 26 4.3.2) Roles in the Portfolio Private equity has positive correlation with public equity because all types of businesses are exposed to economic and industry conditions However, correlation is low due to high company-specific risk involved in private equity VC fund is expected to generate higher returns in case of advancing public equity market values The primary role of Private equity is return enhancement; however, it can play a moderate role as risk diversifier Issues involved in formulating a strategy for private equity investment: FinQuiz.com 1) Sufficient diversification requires large number of positions: Investors with greater than $100 million portfolio value are able to invest in investments required for diversification Private equity FOFs are preferable for small investors to achieve diversification (in spite of higher fees) 2) Low Liquidity of the position: Direct private equity investments are inherently illiquid • Capital has to be tied up for 7-10 years • Limited secondary market exists for private equity commitments • Investments trade at highly discounted prices 3) Provision for capital commitment: • Investors make a commitment of capital • Cash is requested over the commitment period (usually years) • Investors are required to provide capital when future capital calls are made 4) Appropriate diversification strategy: Both the stand alone risk factors of an investment and its effect on the overall risk of portfolio should be taken into account Diversification may be across industry sectors (IT, biotech etc.), by stage of company development (early stage, expansion, buyout etc.) and by location (local, international etc.) Due Diligence items for private equity: 1) Evaluation of prospects for market success: It includes • Markets, competition and sales prospects • Management experience and capabilities; assessment of management is an ongoing process • Management’s commitment: Following factors are used to assess management’s commitment: i Percentage ownership: ownership of a large portion of the company is an indication of high commitment to the company ii Compensation incentives: managers’ interests must be aligned with the shareholders through proper compensation arrangements • Cash invested by managers: Greater cash invested by managers indicates highly committed management team • Opinion of customers: Customers’ opinion of the company’s existing product/service should be evaluated • Identity of current investors: Presence of professional/expert investors related to company business give an indication of company’s future success Reading 26 Alternative Investments Portfolio Management 2) Operational Review: It includes • Expert validation of technology i.e technology that is marketed by a company is valid and represents future advancement • Employment Contracts i.e investors should evaluate whether key employees have contracts to stay with the company • Intellectual property i.e investors should evaluate whether the company possesses relevant patents FinQuiz.com • Examination of financial statements: Investors should analyze financial statements, tax returns and conduct their own audits etc Factors to be considered in evaluating manager’s team (Indirect investment): • Historical returns generated in prior funds • Consistency of returns • Roles and capabilities of specific individuals in the fund • Stability of the team and personnel turnover 3) Financial/ legal review: It includes • Potential for dilution of interest: Investors should evaluate existence of stock options and other means which can dilute their investment interests COMMODITY INVESTMENTS A commodity is a homogeneous and tangible asset • Gives unequal fixed weights to each sector according to its perceived relative importance Types of Commodity Investments Direct Commodity Investment: Refers to cash (spot) market purchase of physical commodities or exposure via derivatives i.e futures • Includes energy, metals, grains, and soft commodities (i.e cocoa, coffee, cotton & sugar) • Uses world production weighting system • Weights are assigned on the basis of five year moving average of world production • The energy sector is over weighted in the index • Provides two versions of indices: i Total return version: It assumes that capital is required to purchase basket of commodities is invested at the risk-free rate ii Spot version: It tracks movements in futures prices only • Sub-indices include agriculture, industrial, livestock, energy precious metals contracts • Due to carrying and storage costs associated with Cash market purchases, derivatives and/or indirect commodity investments are preferred by investors • Derivatives/futures provide good commodity exposure Indirect Commodity Investment: Refers to achieving indirect exposures to changes in spot market values of commodities via e.g investing in equity of companies specializing in commodity production etc • They not provide effective exposure to commodity price changes because these companies themselves hedge commodity risk • ETFs provide partial effective commodity exposure The creation of investable commodity indices and increase in preference to use derivative markets to gain commodity exposure has facilitated small investors to access commodity markets via mutual funds or exchange-traded funds 5.2 Benchmarks and Historical Performance Commodities physical markets are not centralized Therefore, performance of commodity investment can be evaluated through commodity indices Benchmarks: Reuter Jefferies/Commodity Research Bureau (RJ/CRB) Index: • Groups commodities into four sectors Goldman Sachs Commodity Index (GSCI): Dow Jones-AIG Commodity Index S&P Commodity Index Construction: Benchmarks are constructed using a futures-based strategy Bias: Indices differ in composition, weighting scheme and purpose Important Notes: • Market cap weighting scheme cannot be used in commodity futures indices because every long futures position has a corresponding short futures position and market cap of futures contract is always zero • Generally, return on commodity futures contract is not equal to the return on the underlying spot commodity However, Cost of carry model, ensures that the return on a fully margined position in a Reading 26 Alternative Investments Portfolio Management futures contract closely replicates the return on an underlying spot deliverable Historical performance: The difference in performance of different indices can be attributed to the differences in the components of the indices and weighting systems • On a stand-alone basis, commodities have underperformed traditional investments (stocks & bonds) i.e exhibited relatively low Sharpe ratio • Commodities provide diversification benefits because commodities indices have low correlation with traditional asset classes • Energy sector plays a significant role in the positive Sharpe ratio and high volatility of the GSCI • Average correlation of GSCI commodity sector returns is low; thus, commodities not represent a homogeneous market of similar investments Recent Performance: Recent performance indicates that: • All commodity indices outperformed U.S and world equities but underperformed bonds • Correlations with bonds have increased; however, correlations among commodities and traditional asset classes are low Commodity Index Return Components: Returns on Commodity futures contract have three components: Total Return on a Commodity Index = Collateral Return + Roll Return + Spot Return Spot Return/Price Return: It measures the change in commodity futures prices that should result from changes in the underlying spot prices It is calculated as change in the spot price of the underlying commodity over a specified time period Because of carrying and storage costs, when spot price increases (decreases), futures price increases (decreases) and results in positive (negative) return to a long position (Note that convenience yield is already adjusted in the cost of carry model) Collateral Return/ yield: When an investor (long futures contract) has a fully margined position (i.e posts 100% margin in the form of T-bills), he/she can earn riskfree interest rate This return is known as collateral return Roll Return/ yield: Roll yield can be earned by rolling long futures positions forward through time Backwardation: It occurs when longer maturity futures contracts have lower price i.e downward sloping term structure of futures prices In this situation, positive return can be earned through buy-and-hold strategy i.e when futures price < spot price, it increases over time (converges to spot price) as it gets closer to maturity and generates positive roll yield FinQuiz.com Contango: It occurs when longer maturity futures contracts have higher price i.e upward sloping term structure of futures prices Monthly Roll Return = ∆ in futures contract price over the month - ∆ in spot price over the month Note: The closer the futures contract to maturity, the greater the roll return/yield Convenience yield: It refers to nonmonetary benefits from owning the spot commodity It is directly related to roll yield i.e the higher (lower) the convenience yield, the higher (lower) the roll returns It increases during periods of high volatility and demand & supply shocks In addition, it is inversely related to the level of inventory 5.2.3) Interpretation Issues • When commodities are treated as a distinct asset class then commodity indices can be used as benchmarks • When commodities are not treated as a distinct asset class then a customized benchmark should be used • It is necessary to take into account the differences in economic conditions between historical period and current and forecasted future period 5.3 Commodities: Investment Characteristics And Roles Characteristics: In periods of financial and economic distress, commodity prices tend to rise and potentially provide valuable diversification benefits Commodities are generally business-cycle sensitive because of their sources of returns and their demand/supply is dependent on business-cycle Commodities have low or negative correlation with stocks and bonds Reasons behind low correlation: • Commodities have positive correlation with inflation whereas stocks & bonds have negative correlation with inflation • Commodity futures prices are more affected by short term expectations; stocks and bonds are affected by long term expectations • Commodity prices decrease when economy weakens Rationale for including commodities in portfolio: Act as an inflation hedge: They protect portfolio against unexpected inflation Portfolio risk diversifier: They provide (both long-term and short-term) diversification benefits Reading 26 Alternative Investments Portfolio Management Potential for improvement in the Sharpe ratio Determinants of commodity returns: Business cycle-related supply and demand: Prices are determined by supply and demand of the underlying commodities Convenience Yield: Difference b/w spot price and futures price is based on components: 1) 2) i Opportunity costs i.e forgone interest from purchasing and storing commodity Storage costs Commodity’s convenience yield ii iii Real Options under Uncertainty: Producers hold valuable real options (option to produce or not to produce) i.e production occurs only when spot prices > discounted futures prices 3) FinQuiz.com Role of Commodities as Inflation Hedge: Storable commodities (e.g energy, precious metals) are directly related to the intensity of the economic activity and provide superior inflation hedging Non-storable commodities (e.g wheat) are inversely related to the intensity of the economic activity and provide inferior inflation hedging Commodity whose demand is related to Economic activity: Theses commodities tend to provide good hedge against unexpected changes in inflation Commodity whose demand is not related to economic activity: These commodities tend to provide poor hedge against unexpected changes in inflation NOTE: Commodities also provide opportunities for active management that may involve short as well as long positions Note: Mismatches in supply and demand exist only in short term (Samuelson effect) Investors include: • • • • • Institutional investors Corporate and public pension funds Endowments Trusts Bank trust departments Characteristics: They are allowed to avoid certain reporting and other requirements as well as some restrictions on incentive fees Unlike traditional mutual funds, hedge funds are allowed to take aggressive long or short positions and use high leverage They not perform relative to any specific benchmark/index and seek to maximize absolute returns Forms of hedge funds include: i ii iii Limited partnership Limited liability Corporation Offshore corporation Note: Managed futures are now generally classified as hedge funds 6.1.1) Types of Hedge Fund Investments Hedge funds are classified according to the following investment styles HEDGE FUNDS 1) Equity Market Neutral: It involves identifying undervalued and overvalued equities and neutralizing the portfolio’s exposure to market risk (β = 0) through a combination of long and short positions with roughly equal exposure to the related market or sector factors • They have little or no market risk However, hedges may be imperfect • They have low credit risk due to low (net) leverage resulting from long-short positions • Using this strategy, funds have no Correlation with S&P 500 2) Convertible Arbitrage: It involves exploiting mispricing in convertible securities i.e convertible bonds, warrants and convertible preferred stock i.e buying/selling convertible bonds and hedging the equity component of the bond’s risk by taking the opposite position in the associated stock • Hedging risks results in decrease in market exposure • This strategy involves higher credit risk due to high leverage exposure resulting from hedging via derivatives • These strategies have low correlation with stocks and bonds Risks include: • • • • Changes in the price of the underlying stock Changes in the expected volatility of the stock Changes in the level of interest rates Changes in the creditworthiness of the issuer Reading 26 Alternative Investments Portfolio Management Gains include: • Coupon on underlying convertible bond • Short rebate • Rapid increase in expected volatility of the underlying asset increases value of option portion of bond • Improvement in the credit quality of the issuer (depends on the hedge strategy) 3) Fixed-Income Arbitrage: It involves identifying overvalued and undervalued fixed-income securities on the basis of expectations of changes in the term structure of interest rates or credit quality of the various related issues or market sectors Due to the combination of long and short positions, they are neutralized against market directional movements FinQuiz.com due to extensive use of leverage via derivative instruments • They have higher correlation with stocks and bonds relative to other strategies 8) Emerging markets: Refers to investing in emerging and less mature markets Due to restrictions on short selling and lack of derivative markets, short sales are difficult and most funds are long 9) Fund of funds (FOF): FOF invests in a number of underlying hedge funds (typically 10-30 hedge funds) They are generally preferred to be entry-level investments because they provide professional management and facilitate investors to delegate individual manager selection to the FOF manager Advantages: 4) Distressed Securities: These refer to securities of companies that are in financial distress or near bankruptcy Distressed funds invest in the debt or equity of companies experiencing financial or operational difficulty • These securities typically trade at a substantial discount compared to their fair value • Due to relative illiquidity of distressed debt & equity, short sales are difficult and most funds are long • Low correlation with world stock and bond investments • Strategy performs well when the economy is not doing well • Facilitate diversification among hedge fund managers and strategies, • Access to different strategies and expertise, • Shorten the due diligence process to a single manager • Provide a more accurate prediction of future fund returns than that provided by the more generic indices • Provide greater liquidity due to no lock-up period provisions and allow more frequent investor exits • FOFs can represent a better benchmark because they are less affected by survivorship bias Disadvantages: 5) Merger Arbitrage (or Deal Arbitrage): This strategy seeks to generate returns from corporate merger and takeover activity and attempts to exploit the price spread b/w current market prices of corporate securities and their value after successful completion of a takeover, merger, spin-off etc Rule: Buy the stock of a target company after a merger announcement and short an appropriate amount of the acquiring company’s stock 6) Hedged Equity: It involves identifying overvalued and undervalued equity securities However, portfolios are not structured as market neutral and may be concentrated i.e may have a net long exposure to the equity market Hedged equity makes up the largest category of hedge funds in terms of asset size (AUM) • Highly concentrated • Net short or long position 7) Global Macro: It involves taking large positions in financial and non-financial assets to exploit opportunities of systematic (market) moves through trading in currencies, futures and option contracts • They concentrate on major market trends rather than changes in individual security prices • This strategy involves higher credit (leverage) risk • They involve two layers of fees i.e one to the hedge fund manager and other to the manager of FOF, • Exhibit lower performance (lower returns) relative to hedge funds • Requires maintaining cash buffer to meet liquidity needs that results in lower expected returns • They are affected by style classification and style drift • They are more highly correlated with equities relative to individual hedge funds and thus provide less diversification benefits Strategies can also be classified into the following five broad groups (in ascending order of risk involved): 1) Relative Value: Attempt to exploit mispricing in related securities • Have no correlation with the market • Example: Equity market neutral, convertible arbitrage and hedged equity 2) Event Driven: Seeks to generate positive return by exploiting opportunities created by corporate events (i.e merger, bankruptcies, liquidation, buy back, etc.) • Not correlated with market • Example: Merger arbitrage, distressed securities Reading 26 Alternative Investments Portfolio Management is paid until the fund’s NAV > HWM When NAV > HWM, 3) Equity Hedge: Seeks to generate return by reducing market risk (beta) and generating alpha • Long/short managers use fundamental analysis • Investment is done in long and short equity positions with varying degrees of equity market exposure and leverage 4) Global asset allocators: Seek to generate return from an extremely wide variety of trading strategies and asset classes They can take directional views (both long and short) on global interest rate, currencies, commodities, equity 5) Short selling: Equity is shorted in expectation of decline in market price FinQuiz.com Incentive fee = (positive difference between ending NAV and HWM NAV) × incentive fee % • The high NAV establishes a new HWM Rationale for HWM provision: It is used to ensure that the hedge fund manager earns an incentive fee only once for the same gain Hurdle rate: According to hurdle rate provision, no incentive fee is paid to mangers until a specified minimum rate of return is earned by investors Lock-up Period: It is a period prescribed by hedge funds during which no part of investment can be withdrawn (commonly 3-5 years) Afterwards, investments will be redeemed to investors only within specified exit windows e.g quarterly after the lock-up period has ended Rationale for lock-up period: To protect managers from unwinding positions during unfavorable circumstances Note: Both relative value and event driven are Market Independent Five most popular hedge fund strategies include: i ii iii iv v Equity market neutral Hedged equity Merger arbitrage Convertible arbitrage Global macro For two similarly sized hedge funds following the same strategy (all else equal), the fund that charges lower management fee is expected to deliver superior performance Hedge funds with superior past track records can obtain higher than average incentive fees 6.2 Benchmark and Historical Performance 6.2.1 Benchmarks: Hedge Funds benchmarks include both monthly and daily series Monthly hedge fund indices include: Compensation structure of Hedge Funds: It comprises of: Management fee (or AUM fee) + Incentive fee where, Management fee= % of NAV (net asset value) It ranges from 1-2% Incentive fee= % of profits as specified by the terms of the investment Traditionally, it has been 20% but now is approximately 17.5% High Water Mark Provision (HWM):It requires that incentive fees are only based on returns above the highest value achieved over the life of the fund i.e it specifies NAV that a fund must exceed before performance fees are paid to the hedge fund manager Rule: • Once the first incentive fee has been paid, the highest month end NAV establishes a high water mark If NAV then falls below HWM, no incentive fee i ii iii iv v vi vii CISDM: Equally weighted Credit Suisse/Tremont: Weights depend on AUM EACM Advisors: Equally weighted composite of 100 hedge funds Hedge Fund Intelligence Ltd: Equally weighted Hedge Fund.net (a.k.a Tuna indices): Covers more than 30 strategies and are equally weighted HFR: Equally weighted hedge fund indices based on managers reporting to the HFR database of hedge fund returns MSCI: Indices are separated according to asset class and geographical region • Equally weighted • However, at higher levels of aggregation both equally weighted and asset-weighted versions are available Daily Hedge Fund Indices include: i Dow Jones Hedge Fund Strategy Benchmarks Reading 26 ii iii iv Alternative Investments Portfolio Management HFR hedge fund indices MSCI hedge fund Index S&P hedge fund indices: Equally weighted and are rebalanced annually Differences in the construction of the major managerbased hedge fund indices: 1) Selection criteria: Hedge funds are selected to be included in the index according to different selection criteria i.e length of track record, AUM, and restrictions on new investment 2) Style Classification: Different approaches are used by indices to categorize a hedge fund in a specific style index and decision regarding exclusion or inclusion of the fund from the index when it fails to satisfy style classification sensitivities to market factors Thus, volatility of hedge fund based investment portfolios can be reduced through diversification among hedge fund strategies Liquid Alternatives (a.k.a liquid alts): are variety of hedge fund like investment strategies Unlike hedge funds, liquid alts Unlike hedge funds, liquid alts: • • • • • • • Equally weighted • Dollar weighted on the basis of AUM • Both 5) Investability: An index can be directly or indirectly investable Most of the monthly manager-based hedge funds indices are not investable but most of the daily hedge fund indices are investable (i.e in case of FOFs) Alpha Determination and Absolute Return Investing Hedge funds focus on absolute returns and have no direct benchmark portfolios Therefore, it is difficult to determine alpha in hedge funds However, to determine alpha in hedge funds, following two methods can be used: 1) 2) Single-factor or multi-factor methodology Optimization to create tracking portfolios with similar risk and return characteristics 6.2.2 Historical Performance • Historically, hedge funds have shown superior return performance relative to other traditional asset classes • They provide risk diversification benefits due to their low correlations ( weekly) Using the compounded monthly returns but S.D calculated from non-compounded monthly returns Writing out-of-money puts and calls on a portfolio: This involves earning the option premium without paying off for several years It results in overstated Sharpe ratio Smoothing of returns: Infrequent marking to market of illiquid assets and understatement of monthly gains and losses can understate the reported volatility Getting rid of extreme returns (best and worst monthly returns each year): This can be achieved FinQuiz.com by using total return swap i.e one pays the best and worst returns for one’s benchmark index each year and the counterparty pays a fixed cash flow and hedges the risk in the open market Options can also be used when swaps are not available Sortino Ratio: = (Annualized rate of return – Annualized risk-free rate*) / Downside Deviation * Minimum acceptable return or risk free rate is typically used Gain-to-loss Ratio: It measures ratio of positive returns to negative returns over a specified period of time The higher the ratio, the better it is ൌ൬ number of months with positive returns ൰ number of months with negative returns average up െ month return ൈ൬ ൰ average down month return Calmar ratio = Compound Annualized ROR / ABS* (Maximum Drawdown) Sterling ratio= Compound Annualized ROR / ABS* (Average Drawdown - 10%) Correlations: They are used to evaluate portfolio diversification and are only appropriate to use for normally distributed returns where, *ABS = Absolute Value Skewness: Skewness is a measure of asymmetry in the distribution of returns Symmetrical distribution has zero skewness Investors prefer positive skewness Kurtosis: Kurtosis evaluates how close or far from the mean, returns are clustering Investors prefer low kurtosis Consistency: Consistency analysis is primarily useful when funds of the same style or strategy are compared It is important to analyze the number of months that the strategy has had positive (or negative) returns, the number of months that the strategy has had positive (or negative) returns when the market is up (down), and the average monthly returns in up and down markets • Investors prefer that a fund should have a greater % of positive returns and less negative than the benchmark in all market conditions Practice: Exhibit 27 & 28, Volume 5, Reading 26 Reading 26 Alternative Investments Portfolio Management FinQuiz.com MANAGED FUTURES Managed futures are private pooled investment vehicles that invest in cash, spot and derivative markets Characteristics: Classification of managed futures: Investment style e.g Systematic or discretionary Markets traded e.g currency or financial Trading strategy e.g trend following or contrarian 1) 2) 3) Able to use leverage in a variety of trading strategies Generally structured as limited partnerships that is available only to institutions and high-net-worth individuals Managed futures are generally viewed as a subset of global macro hedge funds Like hedge funds, managed futures are classified as skill based investment strategies • Trend following strategy provides less diversification relative to contrarian strategy Trading Strategies: Systematic Trading Strategies: Refer to rule-based trading strategies which are frequently trend following Discretionary trading strategies Refer to trading strategies based on portfolio manager judgment rather than rules It involves use of fundamental economic data and trader beliefs Like hedge funds, they are described as absolute return strategies • Available both as private commodity pools and separately managed accounts • Publicly traded commodity funds for small investors are also available • Compensation arrangements are similar to that of hedge funds i.e • Compensation structure: management fee + incentive fee Commonly it is 2% + 20% Comparison Managed Futures Hedge Funds Trade exclusively in derivative markets Mostly trade in spot markets and use derivatives for hedging Tend to focus on return opportunities in macro (index) stock Trade in individual securities i.e tends to focus on micro (security) stock and bond markets Highly regulated relative to hedge funds Loosely regulated 7.1 Managed Futures Market Managed futures strategies are based on the use of professional money managers On the basis of markets, managed futures have the following classification: Financial i.e financial futures/options, currency futures/options and forward contracts Currency i.e currency futures/options and forward contracts • Diversified i.e financial futures/options, currency futures/options and forward contracts as well as physical commodity futures/options Size of the Managed Futures Market: According to AUM, managed Futures industry is probably approximately< 10% the size of the hedge fund industry 7.2 Benchmarks and Historical Performance The benchmarks for managed futures are similar to those for hedge funds 1) Mount Lucas Management Index (MLMI): • It is an investable benchmark for actively managed derivative strategies • It takes both long and short positions in a number of futures markets based on a technical (moving average) trading rule 2) Dollar weighted CISDM CTA$ benchmarks 3) Equal weighted CISDM CTEQ benchmarks General partners in managed futures are known as commodity pool operators (CPOs) Bias: Benchmarks for managed futures require special weighting system Professional commodity trading advisors (CTAs)are hired by CPOs to manage money in the pool Historical performance Both CPOs and CTAs are registered with the U.S Commodity Futures Trading Commission and National Futures Association (self-regulatory body) • CISDM CTA$ exhibited higher Sharpe ratio relative to equities but not relative to bonds • CISDM CTA$ has slightly negative correlation with equity indices Reading 26 Alternative Investments Portfolio Management • CISDM CTA$ has similar correlations with U.S and global bonds i.e 0.42 and 0.46 respectively • The overall dollar-weighted and equal-weighted indices have high correlation with diversified, financial, and trend following strategies and low correlation with currency and discretionary strategies • Across CTA strategies, they have low correlation with U.S equities and low to moderate correlation with U.S bonds 7.3 Managed Futures: Investment Characteristics and Roles Investment characteristics: Derivatives markets are zero-sum games This implies that the long-term return to a passively managed, unlevered futures position should equal to the risk-free return on invested capital less management fees and transaction costs In order to produce positive excess returns (on average), there must be a sufficient number of hedgers (who pay risk premium to liquidity providers) or other users of the derivative markets who systematically earn lower than the risk-free rate CTAs are not restricted to exploit arbitrage opportunities Mostly, momentum strategies are followed by actively managed derivative strategies Momentum trading tends to provide useful information regarding positive skewness to managed future returns It is easier to take short positions in futures; thus, it is possible to earn positive excess returns in falling as well as rising markets Managed futures facilitate investors to employ strategies available in a cash market at a lower cost Managed futures also provide strategies that are not available to cash investors FinQuiz.com Roles in the Portfolio: Provides diversification benefits because they have low and/or negative correlations with traditional asset class They provide better risk-adjusted performance Managed futures help to optimally allocate investment capital i.e when stocks and bonds underperform due to rising inflation concerns, certain managed futures may outperform in such conditions Important: • Managed futures appear to have negative correlation with traditional investment vehicles when cash markets incur significant negative returns • Managed futures appear to have positive correlation with traditional investment vehicles when cash markets incur significant positive returns Sharpe ratio increases when they are added to traditional portfolio Other issues: • Past CTA performance can be reliably used to forecast CTA and multi-advisor CTA portfolio’s return and risk parameters (particularly at portfolio level) • Because of the use of derivatives and leverage like in hedge funds, they require similar due diligence as that of hedge funds In addition, significant attention should be paid to the risk management practices of CTA Practice: Example 14, Volume 5, Reading 26 They facilitate investors to gain exposure to unique sources of return and thus provide diversification benefits DISTRESSED SECURITIES Distressed Securities are the securities of companies that are in financial distress or near bankruptcy In U.S., investing in distressed securities involves: • Purchasing the claims of companies that have already filed for Chapter 11* (protection for reorganization) or • Purchasing the claims of companies that are expected to file for Chapter 11 in near future *Under chapter 11 protection, companies try to avoid chapter (i.e protection against liquidation) through an out-of-court restructuring of debt with their creditors • Opportunities for managers exist due to the following reasons: o Relatively under-researched by analysts o Many investors are unable to hold belowinvestment-grade securities 8.1 Distressed Securities Market The market opportunities for distressed securities strategy Reading 26 Alternative Investments Portfolio Management • Increase with the increase in default rates on speculative grade bonds and • Decrease with the increase in the number of distressed debt investors seeking to exploit mispricing in such securities 8.1.1) Types of Distressed Securities Investments There are two major structures through which investors can access distressed securities investing: Hedge fund structure: It is considered to be the dominant type Advantages • Facilitate to take in new capital on a continuing basis • AUM fee and incentive structure (particularly when there is no hurdle rate) is more profitable relative to other structures • Provide more liquidity to investors (i.e can withdraw capital more easily) Private equity fund structure: They have a fixed term and are closed-end Advantage • Preferable to use when assets are illiquid or difficult to value Other structures include: Bias: Popularity bias, survivorship bias, backfill bias, selfreporting bias 8.2.2) Historical Performance Distressed securities exhibit non-normal distribution of returns (particularly negative skewness and high kurtosis) Thus, they are affected by downside bias Therefore, it is not appropriate to use Sharpe ratio as a risk-adjusted performance measure Characteristics: • High Sharpe ratio • High mean returns • Low S.D.; however, due to negatively skewed distribution, risk measured by S.D is understated • Low correlation with traditional portfolio which leads to higher return and lower risk • Performance is largely dependent on business cycle and economic activity i.e o When economy performs weakly → bankruptcies increase → strategy is profitable • Success of strategy also depends on the ability to accurately predict whether an event will occur or not (i.e event risk) Note: It is not necessary that all non-investment-grade or high-yield bonds are distressed securities Strategies of investing in Distressed Securities • Hybrid structures consisting of both hedge fund and private equity • Separately managed accounts • Open end investment companies (mutual funds) Types of assets in which distressed securities managers invest in include: Distressed Debt Arbitrage: It involves buying the traded bonds of bankrupt companies (at large discounts) and selling the common equity short This approach is commonly used by Hedge Funds • When the company’s prospects improve: value of company’s debt and equity increases but the debt is expected to appreciate more in value relative to equity due to senior claim enjoyed by bonds • When the company’s prospects worsen: value of company’s debt and equity decreases but the equity (in which manager has short position) is expected to decline more in value relative to debt 8.2.1) Benchmarks Construction: Either equally-weighted or AUM weighting system is used Long-only Value Investing: It involves investing in perceived undervalued distressed securities in expectation of an increase in its value • When the distressed securities are public debt, it is known as high-yield investing • When the distressed securities are orphan equities, it is known as Orphan equities investing Publicly traded debt and equity securities of the distressed company Orphan equity: It refers to investing in a newly issued equity of an undervalued company (after reorganization) Bank debt and trade claims ‘Lender of last resort’ notes Different derivative instruments for hedging purposes i.e CDS Distressed securities (from hedge funds perspective) are often classified as a sub-style of event-driven strategies All major hedge fund indices (i.e EACM, CISDM and HFR) have sub-indices for distressed securities FinQuiz.com Private equity: It involves an active-value approach Active-value approach: The objective of active involvement is to increase the value of the distressed company by utilizing the company’s assets more efficiently Active approach involves proactively/aggressively protecting and increasing the value of their claims Reading 26 Alternative Investments Portfolio Management Relative-value approach: In this approach, passive investors buy distressed securities to either hold them in expectation of value appreciation or trade them with relatively short period of time A variation of active-value approach is Prepackaged Bankruptcy in which distressed debt is converted into private equity In this approach: • The firm takes a dominant position in the distressed debt of a public company • Afterwards, firm seeks to become the majority owner of a private company on favorable terms • When company’s prospects improve afterwards, company can be sold to private or public investors Investors exhibiting this Private equity approach are known as “Vulture” investors; and their funds are called “vulture funds” or “Vulture capital” Effects of outcomes of prepackaged bankruptcy on the various parties involved: a) Pre-bankruptcy Creditors of the company: Creditors agree in advance with the Debtor Company regarding the plan or reorganization before bankruptcy has been filed and make concessions in return for equity of the reorganized company b) Pre-bankruptcy Shareholders of the company: These shareholders have less leverage relative to creditors and they typically lose their entire stake in the company as the vulture investor (private equity firm) seeks to become a majority owner of the new private equity c) Vulture Investors: The vulture investor bears a lot of risk and when the company’s prospects improve afterwards, company can be sold to private or public investors 8.3.1) Investment Characteristics of Distressed Securities • Potential of high returns from exploiting mispricing i.e security selection • Sources of investment opportunities include: a) Fallen Angels: Securities that are downgraded from investment grade to high-yield These are different from originally ‘high-yield’ securities (i.e securities issued by firms with high risk profile and existing senior debt) b) Failed leveraged buyouts • It requires access to specialist skills and experience in credit analysis and business valuation • Both potential outcomes of the company as a going concern and liquidation value need to be assessed • It requires evaluation of the sources of the FinQuiz.com company’s problems, core business & financing structure • Investing in distressed securities requires legal, operational and financial analysis • The strategy is based on “company selection” because each distressed situation has a unique approach and solution Distressed Securities are suitable for investors with: • High risk tolerance • Long time horizon NOTE: Distressed securities are not riskier than traditional asset classes in all respects During recession, there are more bankruptcies that result in increase in the supply of distressed securities and thus decrease in their prices Therefore, it represents a good time to invest in distressed securities when the economy faces recession Risks associated with Private Equity Investing: 1) Event Risk: Event risk is associated with companyspecific or situation-specific risks and thus has low correlation with the general stock market It is considered a major risk in distressed securities investing 2) Market Liquidity Risk: Distressed securities have relatively low liquidity and market liquidity is largely determined by demand and supply for securities that can be highly cyclical in nature This is a major risk in distressed securities investing 3) Market Risk: Market risk is associated with economy, interest rates and state of equity markets This is not considered a major risk in distressed securities investing 4) J Factor Risk: J-factor risk refers to the risk investors in distressed debt face from judicial decisions Other risks include: • Lack of information about other investors • Risks associated with legal proceedings i.e uncertain nature of the outcome of legal proceedings makes analysis of such investment a challenging task and requires extensive due diligence • Distressed securities are nonmarketable at the time of purchase • It is difficult to value holdings in distressed securities because strategy outcomes are based on long time horizon • Difficult to estimate true market value of securities which consequently results in stale pricing In case of stale valuations, risk of this strategy is understated and Sharpe ratio is overstated • Its return distribution is not normally distributed i.e has negative skewness and positive kurtosis Reading 26 Practice: Example 16, Volume 5, Reading 26 Practice: End of Chapter Reading Problems for Reading 26 & FinQuiz Item-set ID# 10239, 10243 & 13008 Alternative Investments Portfolio Management FinQuiz.com ... and positive kurtosis Reading 26 Practice: Example 16, Volume 5, Reading 26 Practice: End of Chapter Reading Problems for Reading 26 & FinQuiz Item-set ID# 10 239 , 102 43 & 130 08 Alternative Investments... in all market conditions Practice: Exhibit 27 & 28, Volume 5, Reading 26 Reading 26 Alternative Investments Portfolio Management FinQuiz. com MANAGED FUTURES Managed futures are private pooled... PreIPO Mezzanine Preparation for IPO FinQuiz. com Provides capital to prepare for the IPO-often a mix of debt & equity Reference: CFAI Curriculum, Reading 26, Exhibit 10 The Supply of Venture